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Oil is only the darkest of the clouds obscuring Bank of Canada’s rate path

Kevin Carmichael

Published: December 5, 2018 - 5:15 PM

In October, the Bank of Canada said it could finally see home on the horizon. Then a storm rolled in.

Canada’s central bank left its benchmark interest rate unchanged at 1.75 per cent on Dec. 5, and it seems likely the pause will last longer than many had expected just a day earlier.

Negatives outweigh positives in the Bank of Canada’s new policy statement, a shift from October, when Governor Stephen Poloz and his deputies raised interest rates a quarter point. The biggest concern is oil, an important source of export income. Policy makers had been holding out hope that Canadian prices might recover somewhat. Now, they say the desperate situation in Alberta likely means the energy industry’s contribution to economic growth will be “materially weaker” than expected only a couple of months ago.

The darker tone caught traders by surprise. The value of the Canadian dollar plunged, and the prices of financial assets tied to short-term interest rates imply that the official borrowing rate will remain unchanged for the remainder of the winter at least. At the start of the week, those markets were predicting a quarter-point increase in January.

“The timing of the next few hikes could be delayed,” Sébastien Lavoie, chief economist at Laurentian Bank Securities, advised his clients in an email. “We continue to project the overnight rate target to end 2019 at 2.25 per cent, but the next hike may only occur in the spring or summer of 2019.”

The central bank’s October outlook was based on a price for Western Canadian Select of about US$35 per barrel, the prevailing price at the time. Policy makers said then that there was a chance prices would rise once idled refineries got back to work. Instead, conditions worsened. The price of WCS currently is around $30, but only because Rachel Notley, the Alberta premier, ordered the province’s biggest oil companies to curb production.

“Oil prices have fallen sharply since the October Monetary Policy Report, reflecting a combination of geopolitical developments, uncertainty about global growth prospects, and expansion of U.S. shale oil production,” the central bank said, adding that Canadian prices are even weaker because of “transportation constraints” and higher inventories.

“In light of these developments and associated cutback in production, activity in Canada’s energy sector will likely be materially weaker than expected,” the statement said.

Oil is only the darkest of clouds that obscure the central bank’s path back to a more neutral policy setting, which it defines as a rate between 2.5 per cent and 3.5 per cent, the range at which borrowing costs neither help nor impede economic growth.

A return to that theoretical place was beginning to seem possible for the first time since the Great Recession.

The economy had been consistently strong for a couple of years; it grew three per cent in 2017, and still was growing at an annual rate of two per cent in the third quarter, which is about as fast as the central bank estimates the economy can grow without triggering inflation. With the jobless rate at the lowest level in at least 40 years, policy makers made a point of saying that they continue to believe that interest rates will need to rise to a “neutral range” if they are to stay ahead of inflation.

But the timing is now in doubt because developments this autumn mostly have been negative. Apart from oil, the Bank of Canada observed that indicators suggest that the economy had “less momentum going into the fourth quarter,” that U.S. President Donald Trump’s trade wars are “weighing more heavily on global demand,” and that many of the world’s biggest economies suddenly are struggling.

That sentiment jibes with the fear that has gripped financial markets this autumn. Louis Vachon, chief executive of Canada’s sixth-biggest lender, told me in an interview on Nov. 7 that he had turned cautious because he felt the economy was slowing. “We’re late in the business cycle,” he said.

Policy makers may also have a technical reason to take a break from raising interest rates: we might be poorer than we thought.

New estimates of gross domestic product suggest the economy is smaller than in previous estimates. That’s important because it means there could be less pressure to raise interest rates. “Downward historical revisions by Statistics Canada to GDP, together with recent macroeconomic developments, indicate there may be additional room for non-inflationary growth,” policy makers said. They promised a final determination when they update their economic outlook in January.

The latest assessment of the state of play by Canada’s central bankers wasn’t entirely dreary. They expressed confidence that non-energy investment would “strengthen” in the months ahead, suggesting an important economic engine will continue to hum.

Oil notwithstanding, data suggest most industrial companies are struggling to keep up with new orders and will need to add capital if they want to grow. The signing of the new North American trade agreement makes the future more certain, and the Trudeau government’s promise to cut taxes on investment and reduce regulation should make Canada more competitive, the central bank said. Corporate profits also are near record levels, so companies have the means to expand if greed trumps fear.

Still, there is no denying that the Bank of Canada is more cautious than it was a month or so ago. It concluded its statement by saying the pace of interest-rate increases will be determined by a “number of factors,” including the effect of higher borrowing costs on household spending, the trade wars, the “persistence” of the oil-price shock, and the central bank’s “assessment of the economy’s capacity.”